Global financial cris

What Is The Global Financial Crisis And Its Immediate Impact Of On Nedbank, Lesotho?

Introduction

The recent financial crisis which originated in the United States of America, while not a new phenomenon, is peculiar in its severity and global impact. This crisis has created an environment of uncertainty and loss of consumer confidence around the globe. Learning about the global nature of the financial crisis, I became curious to investigate its nature and impact on the Nedbank in Lesotho.

Nedbank is one of the three commercial banks operating in Lesotho with its headquarters in South Africa. Nedbank started its operation in 1997 and received “Diamond Arrow Award” in 2006. Lesotho's national currency, the Loti (Maluti in plural), is fixed at par to the South African Rand. While this arrangement eliminates the foreign exchange risk between the Rand and the Loti, the impact of the global financial crises on the Rand is transmitted to the Loti.

In this essay, I ask: What is the global financial crisis and its immediate impact on Nedbank Lesotho? While the financial crisis has impacted business in general, my focus is on exploring its impact on one bank in order to do an in-depth analysis. I think that this investigation is unique because it will enable me to draw from the theories and concepts of business and management that are usually not discussed in the classroom at our level.

Approach

In this essay, I investigate the impact of the financial crisis on liquidly, flow of funds, foreign exchange, losses, corporate finance, loans and interbank transfers on Nedbank. I will also discuss steps taken by Nedbank to control the adverse impact and avoid its re-occurrence. First, I discuss the theory of banking and risk management. Second, I identify the nature of crisis, its underlying causes and impact on the American and global economies. Third, I discuss the role of globalization to analyse why the financial crisis that originated in USA became global in nature. Fourth, I investigate the impact of the crisis on Nedbank using data from Lesotho, the annual report of Nedbank and an interview with the Managing Director of Nedbank. Fifth, I discuss the lessons of this crisis for banks, governments and society at large. Finally I present an evaluation of crisis and its links with theory.

Theory Of Banking

(i)Banking Business

Banks perform two seemingly related but distinct functions. First, they are financial intermediaries between depositors and borrowers because deposited money is used by banks to provide loans to individuals and businesses. Deposited money is a liability on the bank where as the loans are assets. The interest earned on loans is a source of income for banks. Second, banks transform assets (loans and credits) into financial instruments such as securities, bonds and other portfolios that are sold to investors to earn money and diversify risks. Banks have to maintain certain funds called “capital” against assets which is fixed by local regulators (normally Central Banks) according to the Basel convention. The various functions of banks have been summarised by Bhattacharya and Thakor in Figure 1.

(ii)Banking Risk Management

As in any other businesses, the banking business also has risks. One of the well known risks which banks faced by banks arising from the default to repay loans/interest by individuals and business who borrow money from bank. Bessis has identified six kinds of risks which banks face as shown in Figure 2.

Credit risk arises from the default of creditors when they fail to repay debts. Liquidity risk comes into play when the value of short term deposit is less than the short term outflows or when bank can't raise money. Market risk arises due to the fall in trading values of securities especially when bank wants to liquidate them. When a bank is unable to cover its losses with the available capital it faces solvency risk. Changes in foreign exchange rates give rise to foreign exchange risks since the value of local currency changes. Change in Interest rates affects earning of a bank and leads to interest rates risks. Banks thus need to manage assets and liability to control risks.

Nature Of Current Financial Crisis

In America, banks had been lending money to buy houses, cars etc without verifying their credit history and the ability to repay the loans by borrowers. The people who borrow money from banks have to mortgage (give legal rights to banks to repossess the item purchased) if they fail to repay the loan. This is the security which banks have against to cover for credit risk. The loan given to people without verifying their credit history and ability to repay is called as ‘sub-prime mortgage'. The banks bundle the mortgages into financial instruments called securities and bonds and sell them to investors to make money and to diversify risks. When Americans with sub-prime mortgage' were unable to repay loans, there was a liquidity crisis with banks. Values of securities, shares and bonds dropped leading to a freeze in the market for securities. Banks had accumulated assets in the form of sold loans and securities whose values had depreciated and there were no buyers for these instruments. This forced banks to write-down these assets resulting in heavy losses. Investors in these securities and shares suffered losses globally.

Causes Of Current Financial Crisis

(I)Low Interest Rates Booming House Prices And Sub-Prime Mortgage

When the house prices are rising and if the interest rates are low, people tens to buy houses in the hope to sell them later at profit. Many people even refinance their existing homes for renovation to take advantage of low interest rates. This is what was happening in America for over a decade. This view has been supported by former President Bush, in a speech to the nation. According to one estimate, “house prices rocketed, rising by $12 trillion between 1997 and 2006, more than doubling over 10 years”. American Banks had been following low banking standards and issuing ‘sub-prime mortgage'. According to Washington Post “subprime mortgages had ballooned to 20 percent of all loans, triple the level of a few years earlier”.

(ii) The Bubble Bursts

When house prices started falling around 2006 (Figure 3), many sub-prime mortgage holders could not sell or refinance their homes resulting in defaults leading to repossession (foreclosures) by banks, which is still happening.

According to USA Today there were 1.9 million foreclosure filings in the first six months of this year, a 15% increase from the first six months of 2008. As shown in Figure 4, house prices fell by about 24% over a period of two and a half years.

Cited in http://news.bbc.co.uk/2/hi/business/7302341.stm

This negatively influenced the prices of securities and bonds which were formed from sub-prime mortgages and being sold as trustworthy instruments. Hence, investors around the globe started incurring heavy losses.

(iii)Toxic Assets In Balance Sheets

Due to the loss of glitter on securities, the loans were neither being bought from banks to create securities, nor the securities already created were being purchased by investors. Consequently, many American banks found themselves loaded with huge assets (being termed as ‘toxic assets') on their balance sheets. The market for toxic assets froze around middle of 2008 and banks started collapsing. Share prices also started tumbling on Wall Street. This observation is supported by Figure 5 which shows the growth and fall of securities from 1995-2008.

Cited in http://news.bbc.co.uk/2/hi/business/7302341.stm

This created a chain reaction in the US financial system. Banks that had money started holding it, creating credit crunch for businesses and interbank transfer. This caused as Bush puts it, “the gears of the American financial system began to a grinding halt”.

(iv)Tax Laws And Repeal Of GSA

In 1997, two changes were introduced in America which may have contributed to the current financial crisis. First, there was an abolition of tax an American had to pay on the sale of a house up to $500,000. This change encouraged American to purchase homes to sell later for profit. This view has been supported by Weidner “This made buying and selling a home for profit the most compelling investment in America”. Secondly after the Great Depression of 1930's in America, a law called Glass-Steagall Act (GSA) of 1933 was enacted that separated the activities of commercial banks and investment banks. This was done to protect commercial banks against market risks. In 1997, however, GSA was repealed which enabled the commercial banks to invest in stock market, thereby exposing them to market risk, as per theory of risk management. This view has been supported by Heakel.

There were two other factors which have contributed to the current financial crisis and both of them demonstrate poor banking standards followed by American banks in the hope of making quick money. First, as stated in the theory of banking, banks are required to maintain certain funds called “capital” against assets (Federal Deposit Insurance Corporation (FDIC) has fixed it at 10% in the USA) to cover for losses as per the Basel Convention. It appears by repackaging sub-prime mortgages into securities and selling them to investors, banks were evading the capital requirement. If there was required capital with banks the liquidity crisis would not have occurred. The sale proceeds of securities enabled banks to grant more loans. Secondly, through the securitisation process the banks transfer credit risk to investors. As explained by Acharya and Richardson (2008) banks

“--ignored their own business model of securitization and chose not to transfer credit risk to other investors”. “The legitimate and worthy purpose of securitization is to spread risk. It does so by removing large concentrations of risk from the balance sheets of financial institutions, and placing small concentrations into the hands of large numbers of investors”.

The American banks were thus trying to evade capital requirement and make money by taking greater risks. This view has also been supported by Kashyap, Rajan and Stein (2008).

(vi)Over-Reliance On Rating Agencies

The mortgage backed securities were provided exaggerated high quality ratings by rating agencies Moody's, Standard and Poor's, and Fitch. It is believed that these agencies used faulty mathematical models to grant ratings. This view has been supported by Hagendoorn, “culture of short-term rewards for long-term risk-taking and fatally flawed mathematical risk models” are some other causes that have contributed to the crisis.

The analysis presented above suggests that fiscal, monetary, legal and regulatory factors contributed to the current financial crisis. Banks failed to perceive risks arising from sub-prime mortgages. By creating mortgage-backed securities banks evaded minimum capital requirement. The flawed ratings provided to securities using faulty mathematical risk models hoodwinked investors. In view of the theory of banking business, the question one may ask is - whether banks were acting as intermediaries between depositors and borrowers or between borrowers and investors?

In the current crisis, risk from credit triggered other risks which indicate that risk factors stated in Figure 2 are inter-related. Therefore a modified model which in my view is more relevant is proposed in Figure 6.

Modified Model Of Banking Risks

On the basis of the theory of risk management, one may ask a pertinent question whether banks had created robust risk control structures or were they taking undue risks to make quick money through commissions? Further question may also be asked about the validity of asset-liability management model for banking business.

Impact Of Financial Crisis

As credit lines with banks in America started drying, there was a credit crunch. In the USA there were many foreclosures which are still continuing, resulting in people loosing their homes. Prices of securities and share started tumbling. According to Grauwe, in one year alone (July 2007 to July 2008) stock prices dropped by 30%, destroying $3.5 trillion of value. Banks like Lehman Brothers suffered heavy losses and collapsed. Some banks filed for bankruptcy while some were sold. According to the FDIC, twenty one banks failed during 2008. Chief Executive Officers (CEOs) of banks either resigned or forced to leave. Businesses could not raise funds resulting in decline in economic growth. Many officials working in regulatory and rating agencies are facing disciplinary actions for violating business models and laid down practices. The financial crisis then spread to other countries leading to a global financial crisis.

European banks also suffered heavy losses both in securities and shares. In the United Kingdom, in one day alone depositors withdrew around £1 billon pound from Northern Rock which was eventually nationalised. According to The Independent 33,000 people became insolvent in the UK. The Chairman of Swiss bank UBS, was forced to resign. In Germany Sachsen Landesbank was sold to its rival Landesbank Baden-Wuerttemberg. In Iceland there were public protests and the government had to resign. The French bank BNP Paribas suspended payments out of its three funds. In Russia[20] unemployment rose by 20%. Values of currencies dropped.

Governments had to pump hefty sums of tax payers' money ($1957.97 billion =3.16% of world GDP), to save those institutions which created the crisis and to save financial systems which would have crippled. This money could have been used for development and growth. In spite of the taxpayers' money being used as stimulus in various countries, what is the surety that this money will yield desired results?

The analysis highlights that the impact of financial crisis included credit crunch, huge financial losses, liquidity crisis, bankruptcy, bank failures, redundancies, fall of government, bank runs and drop in economic growth among others. The Nobel Laureate Amartya Sen calls the current crisis as loss of confidence.

Why Has It Become Global Crises Instead Of Being Confined To The US?

The world has become a global village in which there are linkages and integration in terms of currencies, investment and trade. The banking business has also become global with presence of banks from advanced economies in developing countries and vice versa. The global nature of the current crisis is an evidence of the negative effect of globalisation.

Today, individuals, businesses and banks around the globe do business with each other and invest funds into banks, securities and bonds in countries where they are considered safe and yield good return. Investors around the globe who had invested in shares and securities suffered losses when the values of these instruments fell. Countries like China, India, and Lesotho dependent on export were hit hard as demand for their goods reduced. “Reduction in foreign equity and limited access to overseas lines of credit to domestic sectors” also impacted many countries. Thus, while globalisation has benefits of increasing productivity and incomes, it also reduces the immunity of interlinked institutions to risks and shocks.

Impact On Nedbank

(i)General

An interview of the Managing Director of Nedbank Lesotho, Mr Lazarus Murahwa was conducted on 4th August 2009 for two hours using the interview schedule presented as Annexure A. As such findings of this section are based on the responses to the interview, financial results for the year ended 31st December 2008 of the Nedbank (Annexure B) and data from Central Bank of Lesotho.

(ii)Economy And Export And Their Impact On Nedbank

The responses confirmed the nature of crisis and its causes as stated previously in this essay. Given the small size of the bank, as is evident from its financial statements (Annexure B), the bank had not invested any money in securities or shares on Wall Street. Thus it did not suffer any losses. Nedbank only invests in credible banks in South Africa after making thorough checks on the banks. Commercial banks in Lesotho do not have freedom to invest funds outside Lesotho without the approval of the Central Bank of Lesotho.

There was economic slow down in Lesotho in 2008 from 5.1% to 3.5%. Exports of garment and diamond from Lesotho have been hit. According to the Governor of Central Bank of Lesotho, “global economic downturn has resulted in a significant decline in Lesotho's exports in the first quarter of 2009, mainly diamond and textile exports”. Garment factories and diamond mines retrenched staff. Many Basotho working in mines in South Africa also lost jobs. Government “had to inject a rescue package of Maluti 30 million into the equity fund of a garment factory”. Foreign direct investment expected in diamond mining declined. These events had little impact on Nedbank except that it had planned to invest in diamond mines to expand its own business but it lost that opportunity.

(iii)Impact Of Exchange Rate Variation On Nedbank

There was a sharp decline in exchange rate of rand/loti to dollar and pound in the last quarter of 2008 as shown in figure 7. It, however, did not affect Nedbank adversely since it did not have the business customers who required more loti to import (which would have been good for the business of the bank), or those who did not receive funds from foreign buyers for their export orders and had to raise loans to continue their business operations. There was no extraordinary demand for foreign exchange from its customers either. The rate of rand/loti however improved in the first quarter of 2009 because investors started investing in South Africa and purchased rand. This view is also supported by report of State Bank of Lesotho

Data source: Central Bank of Lesotho/Statistics

(Iv)Impact Of Inter-Bank Transfers And Interest Rates On Nedbank

There is no American or European bank in Lesotho. Therefore, Nedbank did not experience any refusal of inter-bank transfer or loans to domestic business by such banks. There was however no problem of inter-bank transfer between local banks. Nedbank is not aware of any refusal of loan to business by local banks because of global financial crisis. Due to fall in interest rates in South Africa of up to 400 basis points from Dec 2008 to May 2009, Nedbank had to increase its volumes of investments to achieve the interest income target.

(V)Impact On Savings And Loan

In spite of recession and retrenchments, saving deposits increased by 25.8% in 2008 in the Nedbank (Table 1).

Data source: Nedbank financial results 2008

The bank did not face any liquidity problem at any time. It did not reduce its offerings of loan to public or business and is very careful while offering loans. In the words of the MD “Nedbank's policy on loans is very prudent and its loan books are small”. The bank also did not experience any defaults or foreclosures in Lesotho ever since credit crunch started in America.

(Vi)Impact On Management

Nedbank management did not experience any anxiety or uncertainty amongst its staff since the bank was doing ‘business as usual'. Moreover, the bank did not suffer any financial loses. As such the management did not experience any new challenge arising out of the global financial crisis in terms of staff morale. There was not even a single retrenchment in Nedbank during the last year. There are no debates in Lesotho on compensation package of senior bank managers which have surfaced due to global financial crisis.

(Vii)Impact On Regulatory And Monitoring Mechanisms

Nedbank did not feel the need to introduce any new risk management strategy to protect the bank or its customers. It also did not receive any new regulatory instructions from the Central Bank of Lesotho. On the issue of stricter regulatory and monitoring regime for the financial sector in future, the Nedbank's view is that current mechanisms in Lesotho are sufficient and don't need any change unless they become hindrances to banking operations and growth. There are already limitations of what a bank could do and could not do at the international level.

(viii)Impact On Overall Performance

As can be seen from Annexure B, the Nedbank declared a higher dividend in 2008 to its shareholders as compared to 2007. In 2008 there was an earning of Maluti 2.14 per share as opposed to Maluti1.67 in 2007 representing an increase of 28.14%. The headline earnings of the bank also improved to Maluti 42.9 million in 2008 from Maluti 33.3 million in 2007. This represents an increase of 28.5%. Thus the global financial crisis did not adversely affect the overall performance of the bank.

(ix)Conclusions Of Impact On Nedbank

On the basis of the analysis it can be concluded that though the export of garment and diamond affected Lesotho which resulted in staff retrenchment, government injecting rescue package in sick unit and reduction in foreign equity, but Nedbank was marginally affected by these events. It did not suffer any financial losses since it had not invested in shares or securities on Wall Street. It neither faced problem of liquidity nor of inter-bank transfer as there are no American and European Banks in Lesotho. It did not face any defaults. The bank did not reduce offering loans to businesses and individuals. Nedbank did not retrench any staff. It did not introduce any new risk management strategy and was not asked by its regulator to introduce any new control. Its profit margin increased by 28.5% in 2008 as compared to 2007.

Lessons From This Crisis For Society, Banks And Governments

An important lesson for the society is that Individuals should avail credits within their repaying capacity. Banks must learn to (i) grant loans only after establishing creditworthiness (ii) maintain ‘capital' as prescribed by regulating agencies and not flout those norms by creating risky products. Rating agencies must follow transparent and strict norms of awarding rating to securities and follow them honestly.

For governments, the lesson is that while the stimulus packages may eventually revive the crippled banking system, the real challenge is to modernise the fiscal, legal and regulatory framework without creating barriers for growth such that any future finance virus is unable to cripple the national and international financial systems. There is also a need to manage globalisation through coordinated efforts such that interlinked institutions are protected from risks and shocks.

Evaluation

By avoiding laid down banking rules and regulations and disregarding laid down practices, which are based on banking theory, created risks for global economies and financial systems. This provides validity to the theory of banking and risk management. Current financial crisis is also an evidence of global integration of trading and financial systems. Nedbank's integration is with South Africa and it worked within theoretical framework. Any impact on South Africa is likely to impact Nedbank.

Banks take the blame as 33,000 are declared insolvent: http://www.independent.co.uk/news/business/news/banks-take-the-blame-as-3 of the year3000-are-declared-insolvent-1769191.html. Accessed on 9 August 2009.

Weber, T. How bad is the crisis going to get? http://news.bbc.co.uk/2/hi/business/davos/7859179.stm. Accessed on 11 Feb. 2009

op. cit p. 3

Russia: Credit Crunch Hits Hard; Sky News. Saturday January 24, 2009.

Banks take the blame as 33,000 are declared insolvent: Accessed on 9 August 2009 http://www.independent.co.uk/news/business/news/banks-take-the-blame-as-3 of the year3000-are-declared-insolvent-1769191.html

Thorat, U, Impact of global financial crisis on Reserve Bank of India (RBI) as a national regulator. http://www.bis.org/review/r090716e.pdf. Accessed on 23 July 2009.

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